Germany's real woes

When in doubt, do nowt. It is a fair measure of the degree of confusion in the bond markets that while some traders were expecting a modest cut in the German repo rate after the Bundesbank meeting yesterday, others were suggesting that the central bank might even push the rate up a bit (it had cut it last week). Sensibly, it left all rates where they were.

The case for a fall in rates was the mounting evidence that the German economy was heading into a 'double-dip' recession - showing negative growth in the first half of last year, picking up a little in the summer and autumn, and now declining again. With inflation, now 3.4 per cent, likely to fall below 3 per cent in the next three months, it could be argued that modest further disarmament was justified.

The case for increased rates was the surge in money supply revealed on Wednesday, which had shot up in January at an annual rate of more than 20 per cent. No matter that this was largely for technical reasons - a change in regulations - everyone knows that the Bundesbank worries about money supply, regarding it as a key, even the key indicator.

But all this is pretty arcane. It is naturally of overwhelming interest to both the bond markets and the foreign exchanges what the Bundesbank does on any one particular day, and this concern will feed through to other European financial markets. But from the perspective of the real world there are two key economic issues in Germany: the likely shape of the recession, and the dreadful state of German public finances.

Both of these will have an impact on Bundesbank policy, on a two- or three-year view at least; but both are ultimately more important determinants of German interest rates than the decisions of a group of people sitting around a table in Frankfurt. Come back to those decisions in a moment; the German recession first.

There is going to be a double dip - that is no longer in dispute. The crucial issue is whether the second dip of the 'W' will be as deep as the first. The balance of conventional opinion at the moment is that it will not, that the bulk of the bad news is out of the way, that the modest growth in export demand will be sustained, and that domestic consumption, hit hard by the fear of unemployment and rising taxes, will recover in the second half of this year.

That is probably right. If it is, the result will be zero growth this calendar year, maybe a small negative, but nothing worse. There is, however, a chance, maybe no more than 25 per cent, that there will be a bit of growth in the first quarter of this year followed by a very difficult summer for Germany, with a further sharp decline in GDP in 1994 and recovery not finally established until well into 1995. Even then, growth in 1995 might well be only 1 to 1.5 per cent.

This sombre economic outlook will worsen the prospects for German public finances. These are already serious. Some calculations by Goldman Sachs suggest that the public sector borrowing requirement was equivalent to 7.2 per cent of GDP last year, and despite tax increases, will only improve to 6.9 per cent this. It will still stand at 3.9 per cent in 1997. As a result of these deficits, government debt as a proportion of GDP, 41.3 per cent back in 1989 before the impact of reunification, will rise to 66.9 per cent by 1997.

It is only a debating point because the Maastricht path towards a single European currency will not be followed, but the fact remains that Germany's public finances are such that it will not qualify to join a single currency on both Maastricht criteria: the running deficit and the share of debt to GDP.

The German fiscal position will have to be attacked soon, but there is no consensus on how. The government view is that there should be some modest increases in taxation and cuts in public spending, particularly on social security. It also assumes improved growth. The opposition prefers larger tax increases and fewer, if any, cuts in public spending. The danger of both approaches is that without supply-side liberalisation of the German economy, growth will continue to be muted.

Black economy

Germany almost certainly has to make larger cuts in public spending if it really wants faster growth. Also, it probably ought to cut taxes, for there is some evidence that high rates have boosted the black economy, thereby further cutting the tax base. Cuts in public spending are certainly what the Bundesbank wants. It will be very difficult, however, to get political support for such a policy.

So two negative forces are coming together - the prospect of a double-dip recession and the continuing need to cut the fiscal deficit at the worst point of the economic cycle. It is quite possible that this conjunction will condemn Germany to very slow growth, not just in 1995 but through most of the rest of this century. Against this background, an obvious question looms: what prospects are there of really sharp cuts in German interest rates, akin to those in the US and the UK, sufficient to give a real kick-start to recovery?

There are two sets of circumstances where this might happen. One would be if there were really dreadful news on the German economy through the second half of this year. The other would be that German rates would come down sharply as a result of co- ordinated rate-cutting by all central banks, perhaps in the wake of another bond and share crash.

Those are two seriously unattractive possibilities. Maybe we should all hope for circumstances that will allow the Bundesbank to plod on in its usual way, cutting rates just a little bit later than everyone else thinks it should.